February 2014

Once deposit rates start rising this year, the banking industry will incur relatively high interest expense due to the inelasticity of consumer deposits in a rising-rate environment.BAI Banking Strategies – February 11, 2014

I think the author makes some decent points throughout the article with his “10 likely scenarios”. However, I almost stopped reading after the opening paragraph (the emphasis is mine):

The question about rising deposit rates is not “if” but when and to what degree they will rise. The timing of the rise in rates is relatively easy to project because rates are dependent on economic conditions.

Really? The timing is relatively easy to project? Perhaps they are for the author, but I seriously doubt it. I wonder if he would have made this prediction about a 2014 rate rise if we had asked him back in January of 2012? What about Federal Reserve officials, you know that ones responsible for monetary policy? What’s their track record for projecting rates? As it turns out it’s not so good.

More than a third of the officials predicted that the Fed would start tightening in 2013. We now know that didn’t happen. Another third predict tightening will start in 2014. But the remaining members don’t see a move until 2015 or 2016. Who is correct? I don’t know. And for the most part no one else does either. That’s why brazen statements like “the timing of the rise in rates is relatively easy to project” really turn me off.

The article makes several good points. The most important being…your A/L model should handle this kind of optionality.

Fortunately for our A/L BENCHMARKS model customers we are modeling early withdrawals. We use a base-case 1% EWR. This EWR or “Early Withdrawal Rate” is akin to the prepayment CPR % we use on the loan side. The difference is that it behaves just the opposite of CPR when we run the interest rate stress-test. The EWR slows down as rates fall, and speeds-up as rates rise.

Shown below is a clip from our documentation. For example if a bank is using the default base assumption of 1% EWR, then when we run the +300bp stress-test the model will change the early withdrawal rate to 13.9%. If a bank feels their penalties are stiff enough this change can be adjusted down (to reflect that the customers are less likely to take their money because of the greater penalty.)